Intentionally Defective Grantor Trusts (IDGTs) and Grantor Retained Annuity Trusts (GRATs) are two popular types of irrevocable trusts. How do you know which one is right for you? This article explains what these trusts are and when they make sense.

Key Highlights and Takeaways

• Two Powerful Estate Tax Strategies: IDGTs and GRATs both save estate tax, but they’re used in different circumstances.
• IDGTs are Tax-Efficient, Flexible Trust Structures: IDGTs are highly estate-tax efficient and make a lot of sense for people who are interested in transferring wealth to future generations and have not used their entire lifetime gift tax exemptions. A grantor can loan to, sell to, and borrow from an IDGT.
• GRATs Efficiently Transfer Volatile Assets: GRATs are ideal for people with volatile, liquid assets who are looking to transfer assets to their children. GRATs transfer assets using an IRS-sanctioned formula where returns above a certain baseline are allowed to pass to the donor’s heirs.

What is an IDGT?

An IDGT is a type of irrevocable trust that is optimized for estate-tax efficiency. A person (the “grantor”) creates an IDGT for the benefit of one or more loved ones — such as children, grandchildren, a spouse, or siblings. The grantor funds the trust using a portion of his or her lifetime gift and estate tax exemption. Once an asset is in the trust, that asset is outside the grantor’s estate and will never be subject to gift tax, estate tax, or generation-skipping transfer tax as long as it remains in the trust. Any resulting appreciation will also be outside the grantor’s estate. Because an IDGT is a “grantor trust,” the grantor has the option to pay the trust’s taxes without that being considered a gift, which is a way to transfer additional wealth to the trust. This makes IDGTs even more estate-tax efficient than they would otherwise be. (You can learn more about IDGTs here.)

IDGT Example

Imagine that Teresa is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Teresa sets up an IDGT for the benefit of her daughter and then contributes a $6 million asset to it, she will use up $6 million of her lifetime gift tax exemption, but the asset will be able to grow outside of her taxable estate. Teresa will also be able to pay the trust’s income taxes, allowing the trust to generate 9% annual post-tax returns and shifting more wealth out of Teresa’s taxable estate. After 25 years, the IDGT’s assets will be worth about $51.7 million! And if Teresa dies in Year 25, she will have saved her daughter about $20.4 million of tax that she would have otherwise owed.

Benefits of IDGTs

1. Estate Tax Savings: The primary advantage of an IDGT is its ability to use a grantor’s lifetime gift tax exemption to efficiently shift assets out of the grantor’s estate for estate-tax purposes. The grantor can pay the income tax on the trust’s income, effectively shifting even more wealth into the trust and out of the grantor’s estate. Finally, the grantor can lend to the trust free of any tax consequences — loans are another powerful tool that taxpayers use to shift wealth out of their estates.
2. Asset Protection: An IDGT, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, IDGTs can help shield inherited assets from a divorcing spouse.
3. Potential Income-Tax Savings: Although IDGTs don’t provide any immediate income-tax savings, they can indirectly save income tax down the line. That’s because an IDGT can make distributions to other taxpayers, who may be in lower tax brackets. The distribution itself will have no tax consequences, but when those taxpayers later sell the asset, they’ll pay less tax than the grantor would have paid, due to that lower tax bracket. IDGTs can also be transformed into “non-grantor trusts,” which can avoid state income tax.
4. Relative Liquidity: Compared to many other tax strategies, IDGTs have little impact on a grantor’s liquidity. Though the grantor will have transferred some portion of his or her assets to the trust, the grantor can borrow from the IDGT without any tax consequences. Moreover, if the grantor’s spouse is a beneficiary, he or she can receive distributions from the IDGT if necessary.
5. Ideal for Illiquid Assets: Unlike GRATs, IDGTs work well whether funded with liquid or illiquid assets.
6. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to a IDGT when the trust is first funded. As a result, the IDGT is a popular form of dynasty trust.

Drawbacks of IDGTs

1. No State Income Tax Savings: IDGTs don’t save state income tax unless they’re converted to non-grantor trusts.
2. Irrevocability: When a grantor makes a gift to an IDGT, the gift is irrevocable (though the grantor can swap assets in and out of the trust at any time, as long as the swapped assets are exchanged for other assets with equal value).
3. No Direct Control: Typically the grantor does not act as trustee of the IDGT, though he or she can remove and replace the trustee at any time, lend money to or borrow money from the trust, get reimbursed by the trust for the trust’s tax liabilities (if the grantor doesn’t want to pay), and swap assets with the trust.

What is a GRAT?

A GRAT is a type of irrevocable trust that moves assets out of a person’s taxable estate without using that person’s lifetime gift and estate tax exemption. It’s a powerful gift and estate tax strategy. The basic idea is that a person (the “grantor”) transfers an asset to the GRAT and sets an annuity term (usually two years). A portion of the principal is returned to the grantor each year until the end of the term. The exact size of each annuity payment is based on a standardized formula, but basically the grantor is entitled to receive the full amount of the original principal amount plus interest that is based on the government’s interest rate, known as the “7520 rate.” By the end of the term, the original principal (plus some interest) has been returned to the grantor. Any remaining amount in the trust passes to the grantor’s named beneficiaries free of estate tax or gift tax. The GRAT’s magic comes from the ability to transfer wealth to beneficiaries free of tax by simply funding the trust with assets that outperform the 7520 rate. The 7520 rate is equal to roughly 120% of the yield on a 7-Year Treasury Note, so it typically comes out to somewhere in the 3%-5% range. (You can learn more about GRATs here and you can estimate the potential returns here.)

GRAT Example

Imagine that Christine is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If she contributes $6 million to a two-year GRAT when the 7520 rate is 4%, the GRAT will pay her approximately $6.3 million over the course of the first two years. But because the GRAT’s assets are appreciating at 9% while the 7520 rate is only 4%, there will be a remainder left over at the end of Year 2. That remainder — about $500,000 — will pass to Christine’s remainder beneficiary, perhaps a grantor trust for the benefit of her daughter. If Christine decides to set up “Rolling GRATs” — that is, GRATs where the annuity payments are used to fund new GRATs — and she keeps setting up new GRATs each year for 25 years and naming the grantor trust for her daughter as the remainder beneficiary, by Year 25 she will have transferred about $33.1 million to trusts for her daughter, saving her daughter the equivalent of about $14.5 million of tax.

GRATs funded during two-year periods where Christine’s investments performed poorly would fail, but Christine and her daughter would be no worse off than if Christine hadn’t funded the GRAT (aside from the cost of setting up the GRAT).

Note that in this example the GRATs don’t transfer as much wealth as the IDGT described above. But that’s not always the case. If the assumed returns had been higher or more volatile, the GRAT could have easily outperformed.

Benefits of GRATs

1. Estate Tax Savings: The primary advantage of a GRAT is its ability to transfer assets to a grantor’s beneficiaries free of gift tax or estate tax.
2. Ideal for Volatile Assets: Compared to other estate-tax strategies, GRATs are particularly well suited for transferring highly volatile assets. In fact, GRATs thrive on volatility. On average, a GRAT funded with highly volatile assets will generally outperform a GRAT funded with less volatile assets even if the overall percentage growth of the underlying assets is the same.
3. Downside Protection: If GRATs had a motto, it would be “Heads, you win, tails you don’t lose.” A GRAT funded with an asset that drops in value will fail to pass on assets to the beneficiaries, but that failure won’t leave the beneficiaries any worse off than they would have been if the GRAT hadn’t been created. In contrast, with other estate-tax strategies, transferring assets that later drop in value can be tax inefficient.
4. Potential Income-Tax Savings: Although GRATs don’t provide any immediate income-tax savings, they can indirectly save income tax down the line. That’s because a successful GRAT can transfer assets to other taxpayers, who may be in lower tax brackets. When those taxpayers later sell the asset, they’ll pay less tax than the grantor would have paid, due to that lower tax bracket.
5. Relative Liquidity: Compared to many other tax strategies, GRATs have little impact on a grantor’s liquidity. During the term of the GRAT, a portion of the grantor’s assets are in the trust, but the grantor can always borrow from the GRAT without any tax consequences.
6. Direct Control: The grantor can act as trustee of the GRAT during the GRAT term, which means he or she retains direct control over the trust’s assets and how they are invested.

Drawbacks of GRATs

1. GST Inefficiency: A person cannot allocate generation-skipping transfer (”GST”) tax exemption to a GRAT during the annuity period. This makes GRATs less suited to transferring assets to grandchildren or more distant descendants than intentionally defective grantor trusts or other dynasty trusts. Still, GRATs can be a powerful estate-tax strategy alongside other, more GST-efficient strategies.
2. Irrevocability: When a grantor makes a gift to a GRAT, he or she is forfeiting the right to the excess growth above the 7520 rate. That said, if desired, a grantor can prevent too much wealth from being shifted to his or her beneficiaries by “swapping” assets out of the GRAT before the end of the term.
3. Not Ideal for Illiquid Assets: GRATs work very well when funded with liquid assets, but they are often not the best fit for gifts of illiquid assets, like real estate or privately held stock. Illiquid assets in a GRAT will need to be valued at least three different times (upon funding, upon the first anniversary of funding, and upon the second anniversary of funding). The IRS can potentially challenge each valuation. In contrast, liquid assets like public stock don’t need to be appraised at all.

Should You Set Up an IDGT or a GRAT?

IDGTs and GRATs both save estate tax, but they’re used in different circumstances.

IDGTs are highly estate-tax efficient and make a lot of sense for people who are interested in transferring wealth to future generations and have not used their entire lifetime gift tax exemption. Gifts to IDGTs are generally GST exempt, which means that IDGTs can make distributions to grandchildren or great-grandchildren without the distributions triggering any generation-skipping transfer tax. They are well suited to receiving any type of asset — liquid or illiquid. For most high-net-worth people, an IDGT will be at or near the center of their plan to minimize estate taxes.

GRATs are ideal for people with volatile assets that are easy to value, like individual stocks or crypto, who are looking to transfer assets to their children. GRATs are particularly useful for people who have limited unused lifetime gift tax exemption, since GRATs don’t require lifetime gift tax exemption in order to work.

It is important to note that there are lots of other gift and estate tax strategies that may make more sense than a GRAT or an IDGT, depending on circumstances. Those strategies are also worth exploring. Moreover, GRATs and IDGTs are not mutually exclusive; some people set up both.

Conclusion

IDGTs and GRATs are both powerful tax strategies. IDGTs make sense for people looking to transfer assets and are okay using lifetime gift tax exemption. GRATs make sense for people with volatile assets who are looking to transfer assets to a trust without using any lifetime gift tax exemption.

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